Chapter 26

Question 1

NPV on calculator

Answer 1

CF function and CPT NPV

Question 2

When is it okay to use cost of capital as the discount rate?

Answer 2

when the project is equally risky like normal business, like replacing a machine, its in the same line of business.

Question 3

What do we use if the project is unrelated to business?

What does it mean if its very risky?

Answer 3

Use the hurdle rate: the Risk adjusted discount rate.

If its very risky, you want higher adjusted discount rate

The minimum IRR above which a project will be accepted is often referred to as the hurdle rate.

Question 4

When do you accept a project for NPV?

Answer 4

for INDEPENDENT PROJECTS:

Accepting project with NPV> 0 is expected to increase shareholders wealth.

You chose the highest NPV project.

Question 5

IRR calculator

Answer 5

Do the CF function and hit IRR CPT

Question 6

What is IRR?

Answer 6

Rate at which NPV is ZERO and you want NPV to be 1 or positive to accept the project.

Question 7

A increase in discount rate (I) in NPV calculation reduces what?

Answer 7

Reduces the NPV

Question 8

conventional cash flow pattern

Answer 8

A project has a conventional cash flow pattern if the sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows.

Question 9

unconventional cash flow pattern

Answer 9

An unconventional cash flow pattern has more than one sign change.

Question 10

For independent project, which one do we use? IRR or NPV?

Answer 10

BOTH, both give same accept/reject decisions

Question 11

What does mutually exclusive projects mean?

Answer 11

You choose project A over project B. Choosing on excludes the other

Question 12

For mutually exclusive projects, IRR and NPV project rankings may differ when:

Answer 12

The projects have different tiing of CF
The projects are different sizes (CF0)

Question 13

Different reinvestment rate assumptions for IRR and NPV:

Answer 13

IRR assumes CF reinvestment at PROJECTS IRR.

NPV assumes CF reinvestment at cost of capital (more convservative).

Question 14

Pros and cons of IRR

Answer 14

Pro:
IRR can have more than one IRR for UNCONVENTIONAL CF, meaning the CF can change .

Cons:
* It assumes that project’s cash flows are reinvested at the IRR while NPV assumes that those cash flows are reinvested at the project’s required rate of return. It is more realistic to assume the latter.

• For multiple sign changes, a project may have multiple IRRs that are difficult to interpret.

Question 15

(1) ROIC Formula

(2) ROIC Definition

(3) What is NOPAT formula.

(4) After tax opt profit =

(5) After tax opt profit to sales is AKA as:

(6) Ratio of sales to invested capital is AKA as:

Answer 15

ROIC is used to examine if company is creating value for shareholders.

NOPAT is after-tax opt profit / average book value of its tot capital over the period.

After tax opt profit = Net income + after tax interest expense.

After tax opt profit to sales is operating margin after tax.

Ratio of sales to invested capital is Capital Turnover or Asset Turnover.

Question 16

Fullen Machinery is investing $400 million in new industrial equipment. The present value of the future after-tax cash flows resulting from the equipment is $700 million. Fullen currently has 200 million shares of common stock outstanding, with a current market price of $36 per share. Assuming that this project is new information and is independent of other expectations about the company, what is the theoretical effect of the new equipment on Fullen’s stock price? The stock price will:

Answer 16

B) increase to $37.50.

The NPV of the new equipment is $700 million − $400 million = $300 million.

The NPV of this project is added to Fullen’s current market value.

On a per share basis, the addition is worth $300 million / 200 million shares, for a net addition to the share price of $1.50.

$36.00 + $1.50 = $37.50.

Question 17

Capital Allocation Process Key Principals (6)

Answer 17

(1) Decisions based on AFTER TAX CF. not accounting income.

(2) Only considers incremental cash flow, which is what the CF would be in the absence of accepting the project.

Sunk cost are cost that cant be avoided even if the project is not undertaken. This cost are not affected by the accept/reject decision so it should not be included in analysis. EX: Spending 40 mil doing a taste test to see if diet coke is in demand. Your income and CF not affected by this sunk cost.

(3) Consider opportunity cost

(4) Consider externalities - cannibalization.
- Negative: if diet coke is introduced to mrk, some sales of reg coke will be affected.

• Positive: some additional sale that co. made for making the product. Ex. Xerox machine sell its accessories separately.

(5) Timing of CF : Ex, in accounting we depreciate, in cap budgeting, we show the entire outflow in the time which it actually occur.

(6) Do not consider project-specific financing cost : Ex, discount rate captures the cost of capital so we do not count it.

Question 18

Timing options

Answer 18

Timing options allow a company to delay making an investment because it expects to have better information in the future.

Question 19

Real options

Answer 19

Real options are future actions that a firm can take, given that they invest in a project today.

Question 20

Cognitive Errors

Answer 20

Poor Forecasting - incorrectly allocating overhead cost or neglecting how competitors will respond.

Not considering the cost of internal funds - Internal funds are retained earnings, retained earnings is part of equity. There is a cost of retain earnings and that is cost of capital and its not free.

Incorrectly accounting for inflation.

Question 21

Behavioral Biases

Answer 21

(1) Pet projects of senior management.

(2) Inertia in setting the entire capital budget.
- Ex: when mgmt dont spend enough during the year
they try to spend as much as they can so they
dont get less. Managers will return excess funds
to shareholders whenever there is a lack of
positive NPV projects and make a case for
expanding the budget when there are multiple
positive NPV opportunities.

(3) Basing investment decisions on EPS or ROE.
- True if senior mgmt bonus is linked to EPS or ROE.
- EPS does not consider time value of money bc its
accounting metric.

(4) Failure to generate alternative investment ideas.

Question 22

Flexibility options

Answer 22

Flexibility options give managers choices regarding the operational aspects of a project.

The two main forms are price-setting and production-flexibility options.

(1) Price-setting options allow the company to change the price of a product. For example, the company may raise prices if demand for a product is high in order to benefit from that demand without increasing production.

(2) Production-flexibility options may include paying workers overtime, using different materials as inputs, or producing a different variety of product.

Question 23

Fundamental options

Answer 23

Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable. The operator has the option to close the mine when prices are low and open it when prices are high

Question 24

The estimated annual after-tax cash flows of a proposed investment are shown below:

Year 1: $10,000

Year 2: $15,000

Year 3: $18,000

After-tax cash flow from sale of investment at the end of year 3 is $120,000

The initial cost of the investment is $100,000, and the required rate of return is 12%. The net present value (NPV) of the project is closest to:

Answer 24

CFO = -100,000;
CF1 = 10,000;
CF2 = 15,000;
CF3 = 138,000;
I = 12;
CPT → NPV = $19,112.

Question 25

Should a company accept a project that has an IRR of 14% and an NPV of $2.8 million if the cost of capital is 12%?

Answer 25

The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital.

Question 26

The four administrative steps in the capital budgeting process are:

Answer 26

Idea generation
Analyzing project proposals
Creating the firm-wide capital budget
Monitoring decisions and conducting a post-audit